Sole Trader vs Private Limited Company

The primary differences between a sole trader and a limited company revolve around legal structure and taxation. While potentially paying less income tax is a common reason for choosing a limited company structure, it's not the only factor worth considering.

The three main differences are:

1. Legal structure: Sole traders operate as individuals without distinguishing between their business and personal assets. In contrast, private limited companies have separate legal entities.
2. Taxation: Sole traders pay income tax on profits, while private limited companies pay corporation tax on profits.
3. Limited liability: Private limited companies offer shareholders protection against debts, whereas sole traders are personally liable for all business debts.

Sole Trader or Limited Company: Legal Structure

Understanding the legal differences and characteristics between these two business forms is crucial for protecting yourself and your business from a legal perspective.

Sole trader legal: As a sole trader, you are an individual who runs your business and is solely responsible for its debts and liabilities. You are self-employed and not considered an employee of your business. This means you have full control over your business and bear all associated financial and legal risks.

Limited Company legal: A limited company is a separate legal entity from its owners (shareholders) and directors. Under UK law, it has rights and responsibilities, including paying corporation tax on profits the Company earns rather than personal income tax as sole traders do. A limited company owner's assets are typically safeguarded from any liabilities or debts incurred by the business, which limits their losses to just what they have invested and no more.

Sole Trader vs Limited Company: Taxation

Tax is the most common deciding factor between operating as a sole trader or a limited company. Both options have different tax requirements and potential benefits that can significantly impact your financial situation.

Sole Traders Taxation: As a sole trader, you are responsible for paying income tax on your profits through the self-assessment system. Tax is payable on sole trader income at three gradually increasing rates: 20%, 40%, and 45%. Income tax is not payable on total income below the tax-free personal allowance, which is £12,570. Sole traders can claim various expenses against income, which reduces taxable profit and income tax due. HMRC requires you to declare your sole trader income and expenses on a self-assessment tax return.

Sole trader key tax facts:

1. Income tax: Sole traders pay income tax at their rates, which range from 20% to 45% depending on their total income.
2. National insurance: Class 2 NICs are paid flat per week, while Class 4 NICs are calculated as a percentage of annual profits above certain thresholds.
3. VAT registration: If your turnover exceeds the VAT threshold (£85,000 as of 2023), you must register for VAT, charge it on applicable sales, and submit VAT returns.
4. Sole trader registration: To register as a sole trader, you should notify HMRC within three months of starting your trade.
5. Making Tax Digital: From 6 April 2026, sole traders with income of £50,000 or more will need to report under the Making Tax Digital regime, which means reporting income and expenses more often and keeping records digitally.

Limited Company Taxation: When operating as a limited company, your business will be subject to corporation tax instead of income tax. Additionally, if you take money from the Company as dividends or salary (rather than reinvesting it into the business itself), further taxes may be applied, such as dividend or income tax under PAYE. HMRC will normally require a limited company to file an annual return detailing the Company's corporation tax liability. Limited companies must submit annual accounts to Companies House, which include details about profit margins, dividends paid out to shareholders, and any relevant financial statements such as balance sheets or cash flow forecasts.

Limited Company key tax facts:

Corporation tax: Limited companies with profits under £50,000 pay corporation tax at a flat rate of 19%, generally lower than the income tax rates paid by sole traders. Companies with profits over £50,000 will pay more than 19% corporation tax, up to a maximum of 25%.

1. Dividend tax: If you take money from your Company as dividends, you must pay dividend tax based on your income tax bands. However, an annual dividend allowance allows for some tax-free dividend income.
2. PAYE and NICs: If you draw a salary from your limited Company, it will be subject to Pay As You Earn (PAYE) taxes and Class 1 National Insurance Contributions (NICs). Your Company must also make employer NIC contributions to salaries above certain thresholds.
3. Company director tax: A company director must submit an individual self-assessment tax return and pay income tax on qualifying PAYE and dividend income.

Advantages and Disadvantages of a Sole Trader

Advantages of a Sole Trader:

1. Simplicity: Setting up your business as a sole trader is relatively straightforward, with fewer legal requirements than forming a limited company.
2. Fewer reporting requirements: Sole traders have less stringent reporting obligations than limited companies, which can save time and effort in managing your business finances.
3. Total control: Operating as a sole trader means you retain complete control over your business decisions without consulting shareholders or directors.
4. Tax efficiency for smaller incomes: If your income is below the higher tax threshold, being a sole trader may be more tax-efficient due to lower overall taxation rates.

Disadvantages of Sole Trading:

1. Limited liability protection: Unlike limited companies, sole traders do not benefit from liability protection. If your business encounters financial difficulties or legal issues, your personal assets could be at risk.
2. Potential tax disadvantages for higher incomes: If you earn above the higher tax threshold as a self-employed individual (over £50,000), operating as a limited company might offer better tax efficiency through dividend payments instead of salary.

Advantages and Disadvantages of a Limited Company

Advantages of Limited Companies:

1. Limited liability protection: One of the main advantages of operating as a limited company is its protection. Your assets are separate from your business, meaning you're not normally personally liable for any debts or legal issues.
2. Tax efficiency for higher incomes: Limited companies can be more tax-efficient for those earning above the higher tax threshold due to dividend payments and lower corporation tax rates.
3. Professional image: Operating as a limited company may project a more professional image to clients and customers than being self-employed.

Disadvantages of Limited Companies:

1. Incorporation process: Setting up a limited company involves additional paperwork and costs compared to sole trading.
2. Filing requirements: Limited companies have stricter reporting requirements than sole traders, which could lead to increased administration work in managing your finances.

What is Better: Sole Trader or Limited Company?

Making the best decision for your business depends on your individual needs, preferences, and circumstances. When deciding between being a sole trader or a limited company, consider all the important factors, such as financial liability and tax efficiency, as well as longer-term issues like administrative burden, business image, and future growth.

1. Financial liability: If limiting your financial liability is important, forming a limited company may be the better option. As a sole trader, you are personally responsible for any debts incurred by your business, whereas, in a limited company, the responsibility lies with the Company itself.
2. Tax efficiency: Tax efficiency plays an important role in deciding whether to be a sole trader or operate under a limited company structure. Limited companies typically have more opportunities for tax planning and can benefit from lower corporation tax rates than income tax rates faced by sole traders.
3. Administrative burden and accountancy costs: Sole traders generally face less administrative burden than limited companies because they don't need to file annual accounts or adhere to strict reporting requirements imposed on companies by Companies House and HMRC. If simplicity is what you're after, operating as a sole trader might suit your needs better, but remember that an accountant can take on the workload for you. Your accountancy bill will normally be higher when running a limited company because of the extra work involved in meeting HMRC and Companies House requirements.
4. Business image: For some businesses and industries, having the image of being incorporated as a limited company can enhance credibility and professionalism in the eyes of clients or customers. The distinction between a sole trader and a limited company may be less significant for others, so it doesn't warrant any consideration, for example, if you're working as a freelancer or in a creative field.
5. Future growth: Future growth or selling your business may be off your agenda for now, but this might change, especially if a competitor makes you a lucrative offer to buy you out! Expanding the size of your business or taking on employees in the future can be made easier when operating as a limited company. If finding external investment or selling your business is part of your long-term strategy, being incorporated may be more attractive to potential investors or buyers.

Differences in Accounts: Sole Trader vs Limited Company

Sole traders maintain simple financial records, including profit/loss statements. At the same time, limited companies must prepare annual statutory accounts that comply with UK accounting standards (UK GAAP), submit them to Companies House, file corporation tax returns, maintain share capital records, directors' reports, and other mandatory filings. Your accountant's bill will usually be higher with a limited company because there's often more work involved for an accountant than with a sole tradership setup.

Can a Small Business Accountant Help You Decide?

Deciding on how to set up your business best can be challenging, especially when relying solely on information from the internet. A small business accountant can help you make sense of the aspects you don't fully understand and lay out a strategy based on your business's plans.

Starting as a sole trader and switching to a limited company is a common business practice. Seek guidance from a small business accountant when deciding between these options. As your business grows, reassess, and make changes accordingly to stay on track.

"Are you aware that if HMRC suspects you have undisclosed income, they can investigate your finances going back 20 years under COP9? Not sharing all your income details can lead to serious issues, like large fines and legal matters. It's key to report every bit of your income correctly to keep problems with HMRC at bay. Reporting your income is a legal responsibility and keeps you stress-free and financially secure. You can use HMRC Disclosure Services to disclose your income, and for income from abroad, the World Wide Disclosure Facility is available."